The Value of Knowledge Capital

This article is an excerpt from the author’s forthcoming book,Knowledge Capital
(New Canaan, CT: The Information Economics Press, forthcoming 1999).

Indiscriminate discarding of knowledge as an enterprise asset,
whether in the form of accumulated employee training or junking of
legacy software, has its origins in ideas proposed over a century ago
about the value of capital and labor. These theories claim that only
capital assets increase the productivity of labor.

Consequently, the productivity of an enterprise is measured only in
terms of the productivity of its capital, such as return-on-assets or
return-on-investment. The providers of capital are then entitled to
the surplus, called profit or rent.

If knowledge happens to be necessary for labor to make better uses of
capital, that becomes the justification for a higher wage rate for
labor. By this reasoning, those performing the actual labor are not
entitled to collect rent from the knowledge they have accumulated.
Labor can receive only fair compensation for the time worked. The most
they are allowed to claim is to be awarded premium wages and a bonus
here or there.

The above reasoning is not only misleading, but also results in
judging the value of employees on the basis of their wages, rather
than how fast they accumulate useful knowledge. The productivity of
labor is not only a matter of wages. Productivity comes from knowledge
capital aggregated in the employee’s head in the form of useful
training and company-relevant experience.

The individual’s point of view

Let me illustrate this by an example. You hire an untrained person who
meets entry-level requirements, such as literacy, a work ethic, and
socially acceptable behavior traits. His or her wage will be based on
prevailing wage rates for entry-level skills.

Ten years later, that person becomes a manager or expert, earning
three times the entry-level wages. How does a firm justify spending
three times more on the identical person?

The accumulation of company-specific knowledge explains the
difference. During those 10 years, the organization invested anywhere
from a year’s to several years’ worth of salary in helping the
employee to function more effectively. Hardly any of that expense
shows up as a direct cost.

Most of it is in the form of attending meetings, having phone
conversations, keeping up with company gossip, and making errors that,
if corrected, can be charged to learning. None of that contributes to
anything the customer is willing to pay for. Industrial engineers call
such expense “overhead.” I call it money spent on an accumulation of
company-specific knowledge capital. If organizations spend their
money well, employees with 10 years of accumulated knowledge will be
worth more than what the company pays them. In that way, the company
will be recovering the investment on its knowledge capital as
incremental profits.

Let us look at the same situation from the standpoint of the employee.
To increase their earning capacity, employees count on the company to
invest in developing their skills beyond whatever investments they
make on their own, such as reading books, attending courses, and
getting involved in professional activities. However, working for the
company consumes most of the time available to do this.

Therefore, the best hope for raising one’s earning potential is what
shows up on the résumé as experience that is not company-specific.
All employees hope to acquire marketable knowledge that has a greater
value than their compensation. If that happens, the employees will be
able to recover their investments in knowledge by getting promoted to
higher-paying positions. If that does not happen, they can hope to
find better-paying employment elsewhere. They can then collect
incremental profits on their knowledge assets in the form of the
difference in the wage rate they could not get from their current
employer.

If you replace the word “software” wherever the word “knowledge” was
used above, you will find the statements to hold true, except that
open systems software will increase the capacity for knowledge
accumulation at a faster rate, whether seen from the standpoint of the
firm or the employee. If a corporation’s investment in people
increases the value of people faster than their salaries, everybody
gains. The corporation creates employee value-added.
The employee acquires knowledge capital on which he or she can collect
added income.

Tragedy occurs when none of the above works out. This
is the case when the corporation practices and teaches obsolete
skills. Then the employee is not marketable, except at depressed
wages. The recent waves of layoffs from “reengineering” have not
increased unemployment among information workers.

They find other jobs, but with lower compensation. An aerospace
engineer could end up as a manager of a copy shop, working 30 percent
more hours for 40 percent less pay. It is possible to calculate the
“fair” price for the new compensation by writing off the engineer’s
accumulated knowledge capital in aerodynamics and structural design to
zero.

The cost to develop information workers, which I define as an overhead
expense for acquiring company-specific knowledge, is very often much
greater than the depreciation of the fixed assets and greater than
profits for most corporations. The time has come for enterprises to
manage knowledge capital as perhaps their most significant asset.

The marketable knowledge information workers acquire during their
lifetime is the only means to increase their earnings. The potential
lifetime earning capacity of a recently graduated engineer, with a
starting salary of $40,000 and real income growing at 4 percent per
annum, is $6 million. Without the added value from continually
acquired knowledge, the lifetime earnings would be 67 percent less.
This explains why it is necessary for individual information workers
to start managing their own knowledge capital for maximum returns to
themselves as well as to their employers.

The corporate point of view

The calculation of the management value-added makes it possible to
count the worth of the people who possess the accumulated knowledge
about acompany. These are the carriers
of Knowledge Capital®.[1]

They are the people who leave the workplace every night (and may
never return), while storing in their heads knowledge acquired while
receiving full pay. They possess something for which they have spent
untold hours listening and talking, while delivering nothing of
tangible value to paying customers. Their brains have become
repositories of an accumulation of insights about “how things work
here” - something that is often labeled with the vague expression
“company culture.” Their heads carry a share of the company’s
Knowledge Capital, which makes them shareholders of the most important
asset a firm owns, even though it never shows up on any financial
reports. Every such shareholder of knowledge assets in fact becomes a
manager, because information acquisition and information utilization
are the essence of all managerial acts.

The term “management” is used here as applicable to every information
activity that is not directly engaged in the generation of revenues. I
define customers as the people from whom you collect cash. When some
corporate staff unit declares that it caters to other staffers as
“customers,” that is just a misnomer. They are overhead and therefore
remain a part of “management” regardless of their claims.

If a new-hired factory worker spends half a day in general orientation
and indoctrination meetings, he partakes in a managerial activity.
The work of an executive secretary can be also seen as managerial,
since this job involves information gathering, storage, and
dissemination tasks. Meetings, training, consultations, giving advice,
accounting, administration, interviewing, or correcting quality
defects are by this definition all managerial functions, because if
they were fully accounted for, they would be charged to “overhead” and
not to direct costs of sales.

In a typical company, an average employee spends at least one-third of
his or her time acquiring intra-company information that is unrelated
to the delivery of goods or services. Employees in managerial and
staff positions expend all of their time on tasks not directly related
to the delivery of goods or services. More than 25 percent of payroll
dollars in an information-intensive enterprise, and well over 50
percent of the payroll dollars in most government agencies, are
expended on information activities that should be recorded as
managerial overhead.

This learning and talking and listening is expensive and reduces
corporate profits. If that accumulation is ultimately convertible in
greater productivity for the enterprise, then the expense was worth it
by earning a return on the Knowledge Capital investment.

Consider the costs of managerial knowledge accumulated by an employee
over a 10-year period. With full costs of employment at about $60,000
per annum, the decade-long exposure to managerial information would
result in knowledge inputs costing about $150,000. What would be then
the measurable outputs from all of that accumulated knowledge?

Calculating Knowledge Capital®

The management value-added has been previously shown as the net result
of all managerial activities. Management value-added is the net
surplus economic value created by the firm, since the suppliers, the
tax authorities, all labor, and all shareholder expenses are already
fully accounted for.

The creation of management value-added is something that defies the
laws of conservation of energy. These laws state that the output of
any system in the universe can never be greater than its input.
Delivering a positive management value-added must be therefore an act
of creativity that springs forth from something that is intangible, as
if it were an artistic conception. The source of this creative energy
is Knowledge Capital. This ephemeral element can be quantified only
indirectly by observing how much management value-added it yields.

Another way of looking at the same phenomenon is to infer the value of
Knowledge Capital from its periodic yield. If management value-added
is the interest earned from an accumulation of knowledge residing with
the firm, then the value of this principal can be calculated by
dividing the management value-added by the price one pays for such
capital.

Mergers and acquisitions of companies have made the pricing of all
capital explicit.[2] The Standard &
Poor’s 500 companies, which account for approximately 70 percent of
the value of all public traded U.S. companies, had fixed assets worth
an estimated $1.2 trillion at year-end 1995, while showing a market
value of $4.6 trillion.

This suggests that there are intangible assets, generally acknowledged
to be the knowledge assets of a firm, approaching $3.4 trillion. These
assets require a better understanding.

Valuation Attempts

Over the last two decades, numerous attempts have been made to find
ways of reflecting these intangible knowledge assets on financial
reports. Perhaps the best-known firm that publishes supplemental
financial reports on its intangible assets is Sweden’s Skandia
Insurance Company. It accounts for its intellectual capital by
documenting assets not recognized by generally accepted accounting
practices. This is accomplished by issuing a supplementary report
unconnected with the official financial statement. [3]

The supplement includes a valuation of Skandia’s computer systems,
experience with work processes, trademarks, customer lists, and an
assessment of employee competence.

Unfortunately, the attempts to assign a valuation to software assets,
trademarks, experience, and employee know-how have thus far run into
the difficult problem of pricing such assets. It is now widely
understood that the costs of acquiring knowledge and the
profit-generation potentials of such knowledge are unrelated.

The value of intellectual property is in its use, not in its costs.
This means that it is only worth what a customer is willing to pay for
it. Two movies made with the identical actors, for the same $50
million budget, will have totally different valuations if audiences
like one but not the other. The same applies to software, new
ventures, inventions, and employee training. This is why the numerous
attempts that have been made to report the intellectual property of a
firm on its balance sheet have faltered.

Knowledge assets become reflected in the financial accounts only after
there is a merger or acquisition at substantial premiums over book
value. When that happens, such assets become identified by the
nondescriptive phrase allowance for good will. Thereupon they become
subject to depreciation accounting exactly as if they were tangible
equipment.

It seems to me that if companies were allowed to record their
Knowledge Capital in the valuation of their shareholder equity as a
matter of accounting routine, many of the inconsistencies that
currently show up in accounting and tax treatment of company valuation
would vanish.

Market pricing of Knowledge Capital

It is the risk-adjusted interest in future earnings, in excess of the
cost of capital, that an investor is willing to pay for as the value
of any intangible assets. Since investors cannot differentiate between
the price of capital for financial or knowledge investments because
they are intermingled, I use the same price for all capital as a first
approximation. This yields a simple equation:

Knowledge Capital = management value-added / price of capital

This relation makes it possible to prepare a revised balance sheet for
any firm, by adding a line item Knowledge Capital on the asset side of
the ledger, and by increasing (or decreasing) the reported valuation
of shareholder equity by the identical amount.

An Example of Knowledge Capital Valuation: Abbott Laboratories

Abbott Laboratories is an example of a company that has successfully
kept accumulating Knowledge Capital faster than equity capital. It has
a stock market valuation that is a large multiple of its financial
assets. The earning capacity of Abbott Laboratories and its
productivity are gaining not because the company is hoarding financial
assets, but because it is using the capabilities of employees more
effectively.

A great deal of investment analysis is concerned with indicators such
as the market-to-book ratios, where the term “book value” refers to
the shareholder equity. Stocks are overvalued if the market value of
shares rises materially above a trend line for the book values.
However, if one adds the valuation of Knowledge Capital to the
valuation of equity capital, the market valuation of a firm such as
Abbott Laboratories will turn out to be not only consistent over an
extended time period, but also rationally explainable.

I have analyzed a number of corporations using this method and found
that adding Knowledge Capital to book value equity capital shows a
good correlation with the prices investors are willing to pay for
shares of information-intensive enterprises.

How to grow Knowledge Capital

One can view Knowledge Capital as the result of a stream of expenses
that have helped an organization to become more effective over a
period of many years. Meetings are not necessarily wasted, because
they may contribute to greater employee awareness. Training is useful
if it is put to good use by making it possible to reach higher levels
of quality and productivity. Software can become immortal if it is
not discarded but instead reused over and over again.

Almost everything that counts as an accumulation of knowledge is
usually paid for and written off as an overhead expense and charged
against current profits. This decreases profits, increases expenses,
and diminishes Return-on-Management® [4] unless management sets out deliberately to treat
all overhead expense as a potential investment in Knowledge
Capital.

Managers should therefore monitor what portion of their sales,
general, and administrative (SG&A) expenses, plus research and
development (R&D) costs, is frittered away as a one-time happening and
how much of it can be seen as an asset with a residual value.

In the case of Abbott Laboratories, that is an important question,
since more than a half of its stock value is derived from its gains in
Knowledge Capital. The answer can be found in computing the firm’s
overhead-to-asset conversion efficiency.

The 10-year sum of all SG&A expenses for Abbott Laboratories is $18.9
billion. During that period, Knowledge Capital has grown by $8.6
billion. This defines the overhead-to-asset conversion efficiency as
44.3 percent. It means that slightly less than a half of overhead
expenses has been well expended for the benefit of long-term utility.
A way of displaying this steady trend is shown in Figure 1.

Abbott Laboratories has succeeded in generating Knowledge Capital
faster than its SG&A plus R&D expenses. This firm is highly
profitable because its accumulated knowledge can be reapplied without
further expense. Its current SG&A plus R&D is indeed lower than most
of its competitors’, because the company does not have to pay for all
of it in every fiscal year. It recycles SG&A plus R&D at a very low
cost, which saves on expenses and increases the value of each
employee. This is why “knowledge recycling” may become the next
management buzzword.

I have analyzed the overhead-to-asset conversion efficiency of
hundreds of companies and found that a surprising number of companies
suffer from negative conversion efficiency. As they cut SG&A and R&D
during reengineering, their long-term Return-on-Management declines
because their attrition of Knowledge Capital proceeds at a faster rate
than the savings generated from wholesale dismissals of people. There
seems to be a trade-off between indiscriminate cost-cutting and the
demoralization of valuable employees that leads to a suicidal death
spiral.

One of the most efficient instances of overhead-to-asset conversion
efficiency is Microsoft. In the period from 1986 through 1995, the
company gained $8.3 billion in Knowledge Capital while expending only
$10.5 billion for SG&A plus R&D.

To explain Microsoft’s extraordinary overhead-to-asset conversion
efficiency of 79 percent, one has to understand that Knowledge Capital
does not need to reside exclusively in the heads of employees. It also
occupies the mindshare of customers who have expended their own time
and money to became habituated to Microsoft products.

Software as Knowledge Capital

Over 40 percent of all computer budgets is expended on software
“maintenance.” This involves continuous refurbishing of old programs.
It consumes large amounts of money to repair poorly designed and badly
organized translations of business processes into software code.

An additional 10 percent of all computer budgets is expended on new
projects. A close examination of proposals will show that much of the
financial justification for starting anew is to reduce expenditures
for maintenance.

If someone would try to sell a house that requires an annual upkeep
equal to a half of the purchase price, nobody would buy it. A rapidly
deteriorating capital asset is not worth much. Yet the very high
ratio of life-cycle maintenance costs to the original acquisition cost
demonstrates that today’s application software is one of the flimsiest
artifacts that management will ever buy.

The idea of constructing software to qualify as a high-residual value,
low-maintenance capital asset has never been accepted. As Howard Rubin
has put it, “If CIOs were judged the way CFOs are, they would be in
big trouble because they do not know what are their assets.”

In a survey of 2,000 firms, not more than 80 percent had any idea of
the size and quality of their software portfolio. This means that a
big part of the millions of lines of code they own is poorly
utilized.[5] It is clear that
software managers do not have the incentives to invest in an
architecture that is survivable in the long run. The computer people,
the vendors, and the consultants also prefer whatever is new,
fashionable, and quick.

The reason for the flimsiness of application software can be found in
the lack of understanding by most executives that software has become
an increasingly significant store of a corporation’s Knowledge
Capital.

While a comptroller may question the reasons for getting rid of old
forklift trucks, software will be written off without any examination
as to its reuse. Software expenses are now wasted because management
uncritically accepts the view that software is largely unrecoverable
every time technology, the organization, or business practices
experience major changes.

The existing methods of accounting do not recognize that, for most
corporations, the accumulation of expenditures for software over a
10-year period will exceed the value of shareholder equity in about 30
percent of cases. As long as software is treated as an expense that
must realize short-term returns, corporations will be paying many
times over for software that performs similar business functions
without the benefit of any reuse.

Software asset management is perhaps one of the most exciting new
opportunities for accelerating the accumulation of Knowledge Capital,
because it represents an encapsulation of accumulated expert knowledge
that can be purchased in the open market at a fraction of its original
cost. Software should be seen as one of the best means for
accumulating and preserving an enormous amount of information about
the ways a corporation functions.

It should be recognized as a knowledge asset so that it can be managed
as something that keeps growing in value steadily, reliably, and
safely. It must be designed for evolutionary growth instead of keeping
it alive by patching it up until such time as a sudden convulsion
makes it necessary to replace it without much delay.

Management must insist that applications software be preserved by
means of technical designs that accommodate rapid changes in computer
technologies. Management should demand delivery of software
applications that take advantage of innovations in operating systems,
adapt to revisions in organization structure, and take advantage of
any streamlining of business practices. Much of the attraction of the
recently introduced Java language may have its origins in the general
perception that elements of all computer applications should be
reusable by making them capable of running on any computer, on any
operating system, in any network environment.

Insights

If a company scraps 100 forklift trucks before they are depreciated,
that will be recorded as a loss. If 1,000 employees with career-life
learning costs of at least $150 million leave a corporation, none of
the financial reports will reflect that. When knowledgeable employees
leave, they are written off as having no value, even though during
their years of employment the corporation paid for all of the
knowledge they acquired on the job.

The existing methods and concepts of accounting, budgeting, and
planning are biased against anything that is not a tangible asset. No
wonder that many prior attempts to calculate the productivity of
“information” have foundered on the reluctance of the current
stakeholders to be subjected to the sort of measurements that were
previously reserved only for the laboring classes.

Why industrial-era accounting methods have been maintained in the
present information age is for students of corporate power politics to
debate.[6] It should suffice to
remind us that when industrialization induced a shift from the
extraction of funds from feudal land possessions to earning profits on
invested capital, most of the assumptions about how to measure
performance had to change. When the expenses for acquiring information
capabilities cease to be an arbitrary budget allocation and become the
means for gaining Knowledge Capital, much of what is presently
accepted as management of information will have to shift from a
largely technological view of efficiency to an asset management
perspective.

Analysis of corporate financial statements now shows conclusively that
effective information management could have a greater impact on
overall corporate performance than efficient financial management. The
shift of resources from financial to information-based assets has been
noticed. “Knowledge” courses and conferences are the rage. Even
prestige firms such as McKinsey & Company now feature a “director of
knowledge management” and a “director of knowledge development.”

The two-hundred-year dominance of financial capital in establishing
the market value of corporations is now history. The era of the
overwhelming importance of information management has arrived. The
information age is now a reality, because information management can
now be planned, budgeted, and controlled as a corporate input and not
merely as a technology investment.

Information-based strategies cannot be developed unless they are
linked to measures of performance, yet traditional financial
indicators offer little help in this regard. The dependence on
traditional capital efficiency-based measures of performance is why
information finds practically no place among the typical performance
metrics examined by corporate executives, auditors, and investors. Yet
accumulations of information and knowledge are implicitly recognized
every day when companies are bought at a large multiple of their
financial valuation. What’s missing is a way of making information and
knowledge an explicit measure of performance.

The time has come for those responsible for “information management”
to rise to the challenge of placing the management of Knowledge
Capital high on the agenda of every organization.

Paul A. Strassmann is chairman and CEO of the Software Testing
Assurance Corporation. His career also includes service as chief
information systems executive for General Foods, Kraft, and Xerox
(1956-1978), and the U.S. Department of Defense (1990-1993); as vice
president of strategic planning for office automation businesses for
Xerox (1979-1985); and as professor, consultant, and author
(1985-1990). His last position was Director of Defense Information
and Principal Deputy, Assistant Secretary of Defense (Command,
Control, Communications, and Intelligence). Mr. Strassmann was
responsible for organizing and managing the corporate information
management program across the Department of Defense. He had direct
policy, information security, and budgetary oversight for all defense
information technology expenditures. Mr. Strassmann is now visiting
professor of information management at the U.S. Military Academy at
West Point.